US oil: Occidental’s $56bn gamble on finding value in shale
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When Vicki Hollub stood up to speak at Occidental Petroleum’s annual meeting last Friday, she knew she was facing a sceptical audience. After three years as chief executive, she had just agreed the most ambitious move of her career, the $56bn acquisition of rival Anadarko Petroleum, and many investors feared she was overreaching.
Buying Anadarko, one of the largest US independent oil and gas groups, with assets around the world from Texas to Mozambique, will double the size of Occidental. It will also saddle the company with debts of around $50bn, in return for a business that has been failing to cover its capital spending from its operating cash flows. Ms Hollub promised billions of dollars worth of cost savings and productivity gains from the deal, but many investors remain sceptical that she can deliver.
“It is simply outrageous,” said one top 10 shareholder before the meeting. The deal poses several operational risks as well as putting enormous pressure on Occidental’s balance sheet, he warned. Investors’ lack of enthusiasm for the deal was reflected in Occidental’s share price, which dropped to a 10-year low as Anadarko accepted its offer.
Addressing around 100 shareholders in a windowless conference room in the basement of the company’s Houston headquarters, Ms Hollub insisted that the deal was “a unique transformative opportunity” for Occidental. “We will get those synergies” from Anadarko’s assets, she said. “We can operate them better than anybody else. We are the rightful owner.”
Although investors had no opportunity to vote directly on the deal, their votes on other issues, including the appointment of Occidental directors, showed clear signs of discontent. The message was clear: if Ms Hollub was so determined to do this deal, she had better make sure it works.
There was a bigger lesson: 15 years into the shale revolution, investors across the US oil and gas industry want it to start paying off for them.
The surge in US oil and gas production, created by the shale boom, has changed the world. The US acts like a “swing producer”: a source of supply that can respond within months to higher prices by increasing output. As tensions rise between the US and Iran, it provides a reassuring buffer against the threat of an oil crisis. But from its earliest days there have been suspicions that the industry is built on unstable financial foundations.
The small and midsized companies that pioneered the advances in horizontal drilling and hydraulic fracturing that unlocked previously unyielding shale rocks have relied on bank borrowing, and equity and bond sales, to finance growth. A sample of leading exploration and production companies compiled by Bloomberg revealed that total capital spending has exceeded total cash from operations in every year since 2010.
That persistent failure to be financially self-sustaining has weighed heavily on the share prices of US oil and gas companies. Since the start of 2017, the benchmark Brent crude price has risen by about 40 per cent, but the S&P 500 exploration and production sector index has dropped by 16 per cent.
Ms Hollub says she can do better. Through economies of scale, efficient logistics management and superior geological understanding, Occidental aims to improve the performance of Anadarko’s assets and generate sustained free cash flows for investors.
If it can deliver on these promises, it will show the world that the shale industry can have a financially sustainable, long-term future. If it fails, it will sound a warning that shale remains a trap for unwary investors.
To win Anadarko, Occidental had to see off its larger rival Chevron, which took some swift manoeuvring, while the two companies had competing bids on the table. Ms Hollub flew to Omaha, Nebraska for a 90-minute meeting with Warren Buffett on April 28, securing a $10bn investment from Berkshire Hathaway that allowed her to rejig Occidental’s offer to include more cash, avoiding the need to put the deal to a vote of her own shareholders.
“To get the deal done, we had to have those funds. The timing was critical for us,” she told investors. “I am very happy and grateful to Warren Buffett for being there when we needed him.”
In the end, however, winning was relatively straightforward. Occidental made a bid worth around 20 per cent more to Anadarko’s shareholders, and Chevron chief executive Michael Wirth declined to match it. “This was an excellent opportunity for us, but it was not a necessity at any price,” Mr Wirth told the Financial Times. “We simply are not desperate to do a deal.”
For Occidental, the hard part is just beginning. It must now prove that its higher bid was justified.
The key to making the deal work lies about 500 miles west of Houston, in the Permian Basin of Texas and New Mexico, the hottest spot in the US shale oil boom. The sparsely-populated landscape of scrubby mesquite bushes has become a maelstrom of activity, as companies have rushed to exploit what are some of the world’s lowest-cost oil reserves. Production doubled in the three years up to 2019, hitting an estimated 4.1m barrels a day of oil in May. It has accounted for about half of the total increase in US oil production since 2016 and the Permian alone produces more oil than any member of Opec except Saudi Arabia and Iraq.
Anadarko’s portfolio includes a range of operations, from deepwater wells in the Gulf of Mexico to an LNG export plant under development in Mozambique. Many of those assets are up for sale, and a deal to raise $8bn has already been agreed with France’s Total for the LNG project and other operations in Africa. Ms Hollub has made it clear that the real prize is Anadarko’s drilling rights on around 250,000 acres of the Permian. Those assets are worth about $17bn, according to Rystad Energy, a research firm. Ms Hollub told the annual meeting that applying Occidental’s knowhow could add $10bn to their value.
Already one of the largest producers in the Permian region, Occidental is also one of the biggest holders of drilling rights. Jeff Bennett, senior vice-president in charge of its shale operations, says that three years ago it was “probably at the bottom” in terms of performance. Since then, however, he says the business has been transformed.
The company spent a couple of years focused on acquiring and analysing seismic surveys and other data, working out ways to drill wells more precisely. It has since published impressive-looking statistics, purporting to show how that applied science delivers superior performance. The wells it has been drilling in the Delaware Basin, the western section of the Permian, have on average produced 74 per cent more oil and gas than those of Anadarko in their first six months in production.
“Six-month production on its own isn’t important,” says Tom Loughrey, at analysts Friezo Loughrey Oil Well Partners, who adds that Occidental has not yet provided enough information to make a proper judgment. “You need to know what happens after a year and three years and 10 years. You can’t conclude from the data Occidental presented that Anadarko is mismanaging its operations.”
Still, it is widely accepted that the performance of Occidental’s shale division has improved greatly. Andrew Dittmar of Drillinginfo, a research group, describes Occidental as one of the region’s top-tier operators, alongside EOG Resources and Pioneer Natural Resources. That improvement has enabled Occidental to cut its operating cost per barrel in half between 2014 and the end of last year.
“What really pleased me was . . . the speed at which we were able to convert that knowledge that we were developing into ringing the cash register,” Mr Bennett says. “It was remarkable how quickly we were able to mobilise and get that done.”
The long lines of heavy trucks thundering through once-sleepy country towns across the Permian region bear witness to how the oil boom is supported by a colossal logistical exercise transporting rigs, pumps and other equipment and supplies.
Bringing just one well into production can require 600-700 truckloads of sand, which is pumped underground with water and chemicals to hold open small cracks in the rock so oil can flow out. Occidental has invested in a new facility on a 400-acre site in New Mexico, close to its oil developments, that can store sand brought by train all the way from Wisconsin, meaning much shorter journeys for its trucks.
That will now be used to support wells being drilled and brought into production on Anadarko’s acreage, some of which is only about 40 miles away across the border in Texas. A new 68,000 square foot “decision centre”, under construction not far from the sand facility, will be used by Occidental’s scientists and engineers to study wells and work out ways to improve them.
But will applying those scientific and logistical strengths be enough to deliver the success that Ms Hollub needs? The results from Anadarko’s Permian business suggest there is room for improvement. In a recent investor presentation, Anadarko said it expected the division to generate enough cash to cover its capital spending by the end of 2020, but that projected date has been slipping.
For Ms Hollub, the incentive to make the acquisition work will be sharpened by the $40bn of debt Occidental is having to take on before any asset sales, and by the 8 per cent dividend it will have to pay on the $10bn of preference shares sold to Berkshire Hathaway. If the business fails to perform, or if the oil price slumps again, Occidental’s financial position could quickly look precarious.
If the company can achieve in the short term the performance that investors are hoping for, then Ms Hollub will be given the chance to demonstrate that she can deliver even greater benefits in the long term. Occidental is one of the world leaders in using carbon dioxide for enhanced oil recovery: pumping the gas into reservoirs so more of the crude flows out. It has been running tests of the technology in the Permian, and will conduct more this year, with the possibility of launching a first commercial project there in three years’ time.
Shale producers are recovering only between 6 and 8 per cent of the oil in the ground with today’s techniques. If enhanced recovery can increase that to 10 to 14 per cent, as early tests suggest, the consequences for oil production could be enormous.
That potential is likely to keep companies coming back to the Permian despite the shale industry’s poor record for investors.
“We’re very bullish on the Permian,” Mr Bennett says. “Companies are going to learn how to unlock some of the lower-quality rock and create value out of that. And we think there is another phase of recovery in terms of enhanced oil recovery. The Permian being essentially the swing volume in global supply and demand is not going away.”
This article was updated on May 23 with Anadarko and Occidental’s correct revenues for 2018. We apologise for the error
Climate change Occidental progress could be slowed by Anadarko deal
At Occidental’s annual meeting last week a statement from shareholders welcomed the steps being taken to tackle climate change by Vicki Hollub, the chief executive. The statement was backed by Climate Action 100+, an investor group that encourages companies to cut their emissions.
Philip Verleger, an energy economist, says investors’ fears about climate risk and a shift away from fossil fuels explain why many have shunned US oil exploration and production companies.
“The momentum is building,” he says. “If I’m running a large pension fund, the last thing I want to do is own many shares in the oil industry.”
Occidental, which has expertise in managing carbon dioxide emissions, and aims to cut its net emissions to zero, looks better placed than many of its peers to prosper in those changing circumstances. However, its expansion in shale production, including the Anadarko deal, may have pushed it away from that goal.
When carbon dioxide is injected into a “conventional”, or non-shale, reservoir to boost production, in what is known as enhanced oil recovery, the gas generally remains in the rock.
The most successful experiments with enhanced recovery in shale, however, have used what is called the “huff-and-puff” method: pumping carbon dioxide into a well, waiting for a while, and then allowing the oil to start flowing out mixed with the gas.
The carbon dioxide can be collected again and reused, but the oilfield can be a permanent store for the gas only when production stops, typically after four to six years.
Ms Hollub acknowledges that EOR can only be part of the answer to tackling climate change, because there are not enough suitable reservoirs to hold its greenhouse gas emissions.
The added difficulties of using the technique in shale suggest its contribution is going to be even more tightly constrained.
Letter in response to this article:
Give all investors a say in big transactions / From Guy R Jubb, University of Edinburgh Business School, UK